English for Accounting and Auditing

KHÓA HỌC “TIẾNG ANH CHUYÊN NGÀNH TÀI CHÍNH” Với số lượng chỉ khoảng 10-15 học viên/lớp và chương trình học được xây dựng hoàn toàn bởi BST, khóa học EAA sẽ cung cấp nền tảng về tiếng Anh trong lĩnh vực Kế toán Kiểm toán thông qua việc phân tích và cung cấp kiến thức về những thuật ngữ, nghiệp vụ căn bản theo các thông lệ mới nhất của Quốc tế cũng như Việt Nam để sau khi hoàn thành khóa học:  Học viên có được nền tảng tốt để nghiên cứu các chương trình chuyên sâu về lĩnh vực kế toán, kiểm toán như FIA, ACCA, CIA, CPA...  Học viên có thể vượt qua các bài thi tuyển dụng và có thể trả lời phỏng vấn về lĩnh vực kế toán, kiểm toán bằng tiếng Anh.  Đối với học viên là nhân viên văn phòng, học viên có thể nâng cao hiệu quả công việc và làm việc tốt với các tài liệu về kế toán, kiểm toán cũng như tham gia các hội thảo được diễn thuyết bằng tiếng Anh bởi các chuyên gia nước ngoài; có thể làm việc bằng tiếng Anh đối với các đối tác nước ngoài trong lĩnh vực kế toán - kiểm toán. Tìm hiểu thêm thông tin về khóa học và ưu đãi học phí => KHÓA HỌC “FA BASICS” Với số lượng chỉ 10-15 học viên/lớp, khóa học FA Basics với kiến thức bao gồm hai môn FA1 và FA2 của chương trình FIA-ACCA được BST đưa vào giảng dạy với mục tiêu:  Khóa học cung cấp những kiến thức nền tảng về tiếng Anh trong lĩnh vực kế toán tàichính theo IFRS và chuẩn bị những hiểu biết cần thiết nhất để học viên có thể theo học các chương trình FIA, ACCA  Kết thúc khóa học, học viên có thể theo học ngay môn F3 (Financial Accounting) củachương trình ACCA mà không bị bỡ ngỡ vì sự khác nhau giữa chuẩn mực kế toán Việt Nam (VAS) và các chuẩn mực quốc tế (IAS/IFRS) cũng như sự khác biệt về cách hạch toán.  Nắm được phương pháp học và luyện thi ACCA, tạo cơ sở để có thể tự học ACCA về sau.  Tạo cơ sở để học viên nghiên cứu các tài liệu chuyên sâu về Kế toán tài chính bằng Tiếng Anh. Tìm hiểu thêm thông tin về khóa học và ưu đãi học phí => BIG STEP TRAINING Thông tin giảng viên: Mr. Trương Đức Thắng - Tốt nghiệp loại GIỎI, HV Tài chính. - Đã hoàn thành ACCA. - Từng làm việc tại Ernst&Young, Vietinbank, Baoviet Holdings. Chi tiết: Website No. 33, 87 lane, Le Van Hien HOTLINE: 0963.321.401 PREFACE English for Accounting and Auditing has been specifically developed for people studying and working in accounting and auditing who need English to study higher programs or communicate in a variety of situations with colleagues and business partners. In this short course, students will learn the language related to accounting and auditing as well as ways to achieve their goals. English for Accounting and Auditing consists of 5 parts (15 lessons), each dealing with a different area of financial accounting, management accounting, auditing (internal and external), financial management and taxation. Every lesson begins with a Reading which consists of vocabulary and basic knowledge about the subject. Each lesson is followed by Listening videos and Activities (short exercise, brainstorming, or a quiz) and they give students the opportunity to practice the target language with partners in realistic situations, opportunity for discussion. During the course, the lecturer plays an important role in explaining Accounting and Auditing knowledge, providing more learning materials for student to practice as well as acts as an instructor in helping students achieve their goals. Please do not hesitate to contact us if you have any comments about this Reading comprehension, or would like to see additional information or new editions. BIG STEP TRAINING 09/2014 BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 1 Contents LESSON 01: INTRODUCTION TO ACCOUNTING ......................................................................... 2 LESSON 02: ASSETS, LIABILITIES AND THE ACCOUNTING EQUATION ................................. 5 LESSON 03: DOUBLE ENTRY ........................................................................................................ 8 LESSON 04: BASIC ACCOUNTING CONCEPTS AND PRINCIPLES ......................................... 11 LESSON 05: CASH AND CREDIT TRANSACTIONS ................................................................... 21 LESSON 06: TRIAL BALANCE ...................................................................................................... 26 LESSON 07: FINANCIAL STATEMENTS ...................................................................................... 29 LESSON 08: EXTERNAL AUDIT ................................................................................................... 40 LESSON 09: INTERNAL AUDIT .................................................................................................... 54 LESSON 10: CORPORATE OBJECTIVES ................................................................................... 61 LESSON 11: FINANACIAL RATIOS .............................................................................................. 66 LESSON 12: SOURCES OF FINANCE ......................................................................................... 75 LESSON 13: COST CLASSIFICATION ......................................................................................... 84 LESSON 14: INFORMATION FOR COMPARISON AND VARIANCES ....................................... 89 LESSON 15: TAXATION ................................................................................................................ 92 REFERENCES ............................................................................................................................... 99 BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 2 LESSON 01: INTRODUCTION TO ACCOUNTING What is accounting? Accounting is the language of business. Companies communicate their performance to outsiders and evaluate the performance of their employees using information generated by the accounting system. Learning the language of accounting is essential for anyone that must make decisions based on financial information. Accounting is the art of recording, summarizing, reporting, and analyzing financial transactions. Bookkeeping is the practice of recording transactions. Bookkeepers tend to focus on the details, recording transactions in an efficient and organized manner, and they may or may not see the overall picture. Accountants use the work done by bookkeepers to produce and analyze financial reports. Although accounting follows the same principles and rules as bookkeeping, an accountant can design a system that will capture all of the details necessary to satisfy the needs of the business - managerial, financial reporting, projection, analysis, and tax reporting. A good accountant will create a system of financial reporting that gives a complete picture of a business. Therefore accountants are responsible for determining an organization‘s overall wealth, profitability, and liquidity. Without accounting, organizations would have no basis or foundation upon which daily and long-term decisions could be made. The budgets for marketing activities, profit reinvestment, research and development, and company growth all stem from the work of accountants. Accounting is one of the oldest and most respected professions in the world, and accountants can be found in every industry from entertainment to medicine. Two main branches of accounting are financial accounting and management accounting. Financial accounting systems ensure that the assets and liabilities of a business are properly accounted and provide information about profits and so on to external organization: shareholders, customers, suppliers, tax authorities, employees Management accounting systems provide information specifically for the use of managers within an organization. The data used to prepare financial accounts and management accounts are the same. The differences between the financial accounts and the management accounts arise because the data is analysed differently. Financial accounts versus management accounts Financial accounts Management accounts Financial accounts detail the performance of an organisation over a defined period and the state of affairs at the end of that period. Management accounts are used to aid management record, plan and control the organisation‘s activities to help the decision – making process. Limited liability companies must prepare financial accounts by law. There is no legal requirement to prepare management accounts. The format of published financial accounts is determined by local law, by IAS (International Accounting Standards) In principle the accounts of different organization is the same therefore be easily compared. The format of management accounts is entirely at management discretion: no strict rules govern the way they are prepared or presented. Each organization can devise its own management accounting system and format of BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 3 reports. Most financial accounting information is of a monetary nature. Management accounts incorporate non- monetary measures. For example: miles travelled by salesmen, monthly machine hours Financial accounts present an essentially historic picture of past operation. Management accounts are both an historical record and future planning tool. GAAP & IFRS/IAS In the world of financial accounting there are lots of principles and standards to be followed. The IAS, for one, is known worldwide as the International Accounting Standards. Conversely, GAAP, or the Generally Accepted Accounting Principles, is the more Americanized term referring to the accounting standards present in any country. The GAAP basically dictates the rules or standards, as well as the conventions to be followed when one records, summarizes, transacts and prepares financial statements within the nation. In individual countries this is seen primarily as a combination of national company law, national accounting standards and local stock exchange requirements. The concept also includes the effects of non-mandatory sources such as: International accounting standards; Statutory requirements of others countries. In many countries, like the UK, GAAP does not have any statutory or regulatory authority of definition, unlike other countries, such as the USA. There are different views of GAAP in different countries. Although the IASC is a powerful entity, it still does not directly control or set the rules for the GAAP. Whenever the IASC forms a new accounting standard, some nations just try to incorporate that standard into their country‘s existing set of standards. The said standards were already set by the local accounting board of the nation. They will be the ones that influence what will be the GAAP for their jurisdiction. Furthermore, it was last in 2001 when IASB took the role of the IASC in setting the actual IAS. To date, the IASB has been making and implementing new accounting standards, but is named as the IFRS, or International Financial Reporting Standards. Nevertheless, all the other standards, including the IAS, are still included in the IFRS. International Financial Reporting Standards (IFRS) are issued by the International Accounting Standards Board (IASB). International Accounting Standards (IASs) were issued by the antecedent International Accounting Standards Committee (IASC), and endorsed and amended by the International Accounting Standards Board (IASB). The IASB will also reissue standards in this series where it considers if appropriate. All transactions of business are recorded, summarized and posted by accountants. The diagram below shows how items are entered in the ledgers, ultimately to arrive at the financial statements. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 4 Totals Totals Sales credit notes Purchase invoices Sales invoices Wages document s Cheques received and paid Petty cash vouchers Journal vouchers Purchase credit notes Sales day book Wages book Cash book Petty cash book Journal Purchase day book Receivables ledger (memorandum) Payables ledger (memorandum) General ledger 1 Bank account 2 Receivables ledger control account 3 Payables ledger control account 4 Sales tax control account 5 Other accounts Income statement Balance sheet Source documents Books of prime entry Ledger accounts Financial statements DOCUMENTING RECORDING SUMMARISING/ POSTING PRESENTING Posting of individual amounts in memorandum personal accounts BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 5 LESSON 02: ASSETS, LIABILITIES AND THE ACCOUNTING EQUATION The resources controlled by business are referred to its assets. For a new business, those assets originate two possible resources:  Investors who buy ownership in the business;  Creditors who extend loans to business. The total assets of business must are equal to sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and is referred to as the accounting equation: An asset is something valuable which a business owns or has the use of. Assets are items belonging to a business and used in the running of business. They may be non-current assets or current assets. Examples of assets are factories, office buildings, warehouses, delivery vans, plant and machinery, computer equipment, office furniture, investment, cash, a trade account receivable, goods held in store awaiting sale to customers and raw materials held in store by manufacturing business for use in production A liability is something which is owed to somebody else. Liabilities are sums of money owed by a business to outsiders such as a bank or a supplier. They may be non-current liabilities or current liabilities. Examples of liabilities are bank loan, overdraft, salaries and wages payable, trade account payable, interest payable and income taxes payable Owner’s equity represents the owner‘s investment in the business. The amount of owner‘s equity is the amount of assets minus the amount of liabilities. Examples of owner‘s equity are capital introduced, retained profit The basic of a fundamental rule of accounting is the accounting equation. The accounting equation 1: The accounting equation 2: The accounting equation 3: Assets = Capital introduced + (Earned profits – Drawings) + Liabilities Assets = (Capital introduced + Retained profits) + Liabilities Assets = Owner‘s equity + Liabilities Assets = Owner‘s equity + Liabilities BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 6 The accounting equation is the rule of accounting which is that the assets and aggregate of the capital and the liabilities of a business must always be equal. The accounting equation holds at all times life of business. When the transaction occurs, the total assets of business may change, but the accounting equation will remain in balance. To better understand the accounting equation, consider the following examples: a. Obama starts business by paying $30,000 to business‟ bank - Business of Obama receives cash as asset, Cash asset will be $30,000. - Obama gives this cash in the form of capital = Owner's equity will be $30,000. Assets = Owner‘s equity + Liabilities Cash $30,000 = Capital introduced $30,000 + 0 $30,000 = $30,000 b. Obama purchased furniture for cash $10,000 - When we bought furniture with cash, our cash will decrease with $10,000. It means one asset will decrease. - Our furniture asset will increase in business, so we add $10,000 as furniture asset. There will no effect on liability side of accounting equation. Assets = Owner‘s equity + Liabilities Cash $20,000 Furniture $10,000 = Capital introduced $30,000 + No effect $30,000 = $30,000 c. Obama Purchased Goods from Sham on credit of $5,000 - With this there will no effect on cash but new goods asset will increase. This is called inventory or stock asset. So, we will show more $5,000 in asset side of accounting equation. - With we have to pay to sham $5,000, so he is our creditor. This will increase our liability. Assets = Owner‘s equity + Liabilities Cash $20,000 Furniture $10,000 Inventory $5,000 = Capital introduced $30,000 + Trade payable $5,000 $35,000 = $35,000 BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 7 d. Obama sold goods (Cost $1,000) at $2,000 on credit to Bush - Inventory asset will decrease (cost $1,000). - We have to get money of $2,000. So, account receivable will increase with $2,000. - By this dealing we gained $1,000. So, this will increase our initial capital. Assets = Owner‘s equity + Liabilities Cash $20,000 Furniture $10,000 Inventory $4,000 Trade receivables $2,000 = Capital introduced $30,000 Retained profits $1,000 + Trade payables $5,000 $36,000 = $36,000 e. Obama purchased Computer of $3,000 with business cash for personal use. - Cash will decrease $3,000 for payment for buying computer. - Capital will decrease because he withdraws money for personal use. No, business will get power for not paying $3,000 capital in future to businessman Obama. Assets = Owner‘s equity + Liabilities Cash (20,000 -3,000) $17,000 Furniture $10,000 Inventory $4,000 Trade receivable $2,000 = Capital introduce $30,000 Retained profits $1,000 Drawing $(3,000) + Trade payables $5,000 $33,000 = $33,000 BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 8 LESSON 03: DOUBLE ENTRY Earlier transactions in the books of accounts were recorded under single entry system. But this system had some shortcomings as there was not a complete record of all the transactions. Also problems were faced while preparing final accounts. Problems were also faced as there was no self balancing system of accounting which could guarantee, to some extent, the accuracy of the books of accounts. So a need was felt for some uniformly accepted system of accounting which could help in the verification of the accuracy of books to some extent. These problems were solved by the Double Entry System of accounting. This system has totally replaced the single entry system. This system is now followed universally. We know that, since the total of liabilities plus capital is always equal to total assets, any transaction has a dual effect – if it changes the amount of total assets, it also changes the total liabilities plus capital, vice versa. Alternatively, a transaction might use up assets of a certain value to obtain other assets of the same value. We can say then that there are two sides to every business transaction. Out of this concept has developed the system of accounting known as the ―double entry‖ system of bookkeeping, so called because every transaction is recorded twice in the accounts. Double entry bookkeeping is the system of accounting which reflects the fact that: - Every financial transaction gives rise to two accounting entries, one a debit and the other a credit, and so. - The total value of debit entries is therefore always at any time equal to the total value of credit entries. Each asset, liability, item of expense or item of income has a ledger account in which debits and credits are made. Which account receives the credit entry and which the debit depends on the nature of the transaction. Debit entries are ones that account for the following effects:  Increase in assets  Increase in expense  Decrease in liability  Decrease in equity  Decrease in income Credit entries are ones that account for the following effects:  Decrease in assets  Decrease in expense  Increase in liability  Increase in equity  Increase in income BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 9 Double entry bookkeeping allows us to keep the accounting equation always in balance, because every financial transaction gives rise to two accounting entries, one a debit and the other a credit. Double-entry accounting has the following advantages over single-entry: - Accurate calculation of profit and loss in complex organisations. - Inclusion of assets and liabilities in the bookkeeping accounts. - Preparation of financial statements directly from the accounts. - Easier detection of errors and fraud. T-Accounts Transactions are recorded in ledger accounts, also known as ―T‖ accounts because how they are normally drawn up on the page. Each ledger account has a debit side on the left and a credit side on the right. The typical layout of a ledger account is as follows: Name of ledger account Debit side Credit side Examples of Double Entry a. Purchase of machine by cash Debit Machine (Increase in Asset) Credit Cash (Decrease in Asset) b. Payment of utility bills Debit Utility Expense (Increase in Expense) Credit Cash (Decrease in Asset) c. Interest received on bank deposit account Debit Cash (Increase in Asset) Credit Finance Income (Increase in Income) d. Receipt of bank loan principal Debit Cash (Increase in Asset) Credit Bank Loan (Increase in Liability) e. Issue of ordinary shares for cash Debit Cash (Increase in Asset) Credit Share Capital (Increase in Equity) BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 10 Balancing ledger accounts Once all the transactions for an accounting period have been posted to the ledger accounts, the balance on each account can be determined. At the end of an accounting period, a balance is struck on each account in turn. This means that all the debits on the account are totalled and so are all the credits. - If the total debits exceed the total credits there is a debit balance on the account. - If the total credits exceed the total debits then the account has a credit balance. Action: Step 1. Calculate a total for both sides of each ledger account. Step 2. Deduct the lower total from the higher total. Step 3. Insert the result of Step 2 as the balance c/d on the side of the account with the lower total. Step 4. Check that the totals on both sides of the account are now the same. Step 5. Insert the amount of the balance c/d as the new balance b/d on the other side of the account. The new balance b/d is the balance on the account. Example: balance this ledger account: Receivables account Balance b/d 10,000 Transaction A 15,000 Transaction B 5,000 Transaction C 2,000 Transaction D 4,000 Transaction E 5,000 Transaction F 5,000 BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 11 LESSON 04: BASIC ACCOUNTING CONCEPTS AND PRINCIPLES Accounting follows a certain framework of core principles which makes the information generated through an accounting system valuable. Without these core principles accounting would be irrelevant and unreliable. These principles are the building blocks that form the basis of more complex and specialized principles called GAAP or generally accepted accounting principles such as the International Financial Reporting Standards, US GAAP, etc. IASB’s Framework: the Framework for the preparation and presentation of financial statements ('Framework') is a set of principles which underpin the foundations of financial accounting. It is a conceptual framework upon which all IFRSs are based and hence which determines how financial statements are prepared and the information they contain. The Framework is not an accounting standard in itself. The Framework deals with: a) The objective of financial statements. b) The qualitative characteristics that determine the usefulness of information in financial statements. c) The definition, recognition and measurement of the elements from which financial statements are constructed. d) Concepts of capital and capital maintenance. The Accrual basis of accounting Accruals: revenues and costs should be matched in the same time period. Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information. Examples: 1. An airline sells its tickets days or even weeks before the flight is made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet. 2. An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months' rent i.e. 30.00 [$120,000/12*3] because 3 months equivalent of time has expired. 3. A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignored the date when the payment will be made. Accounting standards strictly require accounting on accrual basis. However, there is an alternative called cash basis of accounting. Under the cash basis events are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purposes, etc. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 12 The Going Concern assumption Going concern: the business is expected to stay 'in business'. Financial statements are prepared assuming that the company is a going concern which means that the business will continue in operation for the foreseeable future, and that there is no intention to put the company into liquidation or to make drastic cutbacks to the scale of operations. The status of going concern is important because if the company is a going concern it has to follow the generally accepted accounting standards. Examples 1. An oil and gas firm operating in Nigeria is stopped by a Nigerian court from carrying out operations in Nigeria. The firm is not a going concern in Nigeria, because it has to shut down. 2. A nationalized refinery is in cash flows problems but the government of the country provided a guarantee to the refinery to help it out with all payments, the refinery is a going concern despite poor financial position. 3. A bank is in serious financial troubles and the government is not willing to bail it out. The Board of Directors has passed a resolution to liquidate the business. The bank is not a going concern. 4. A merchandising company has a current ratio below 0.5. A creditor $1,000,000 demanded payment which the company could not make. The creditor requested the court to liquidate the business and recover his debts and the court grants the order. The company is no longer a going concern. Business Entity Concept In accounting we treat a business or an organization and its owners as two separately identifiable parties. This concept is called business entity concept. It means that personal transactions of owners are treated separately from those of the business. Businesses are organized either as a proprietorship, a partnership or a company. They differ on the level of control the ultimate owners exercise on the business, but in all forms the personal transactions of the owners are not mixed up with the transactions and accounts of the business. Examples 1. A CPA has 3 rooms in a house he has rented for $3,000 per month. He has setup a single- member accounting practice and uses one room for the purpose. Under the business entity concept, only 1/3rd of the rent or $1,000 should be charged to business, because the other 2 rooms or $2,000 worth of rent is expended for personal purposes. 2. The CPA received $900 bill for utilities. He paid the whole amount using his business account. $600 is to be considered a withdrawal because only $300 (1/3rd) related to business and the other $600 was for domestic purpose. 3. Assuming each public accounting business is required to pay $100 to a local association of CPAs each month. If the CPA pays that amount from a personal bank account the amount shall be considered additional capital. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 13 Monetary Unit Assumption In accounting we can communicate only those business transactions and other events which can be expressed in monetary units. This is called monetary unit assumption. There are certain other frameworks for reporting business performance such as triple bottom line which focuses on "people, planet profit" the three pillars; corporate social responsibility reporting, etc. Accounting focuses on the financial aspects of the business and that too for matters which can be expressed in terms of currencies. One aspect of the monetary unit assumption is that currencies lose their purchasing power over time due to inflation, but in accounting we assume that the currency units are stable in value. This is alternatively called stable dollar assumption. However, there are exceptional circumstances called hyperinflation when the accounting standards require adjustment of prior period figures. Examples 1. The company's property, plant and equipment on 2009 balance sheet amounted to $2 billion. During 2010 inflation was 10%. The monetary unit and stable dollar assumption prohibits any adjustment to current or prior period figures to account for the inflation. 2. The BP oil spill in Gulf of Mexico was a natural disaster but accounting only reports the financial impact in the form of claims paid, damages paid, cleanup costs, etc. This is due to the limitation imposed by the monetary unit assumption. Time Period Principle Although businesses intend to continue in long-term, it is always helpful to account for their performance and position based on certain time periods because it provides timely feedback and helps in making timely decisions. Under time period assumption, we prepare financial statements quarterly, half-yearly or annually. The income statement provides us an insight into the performance of the company for a period of time. The balance sheet (also known as the statement of financial position) provides us a snapshot of the business' financial position (assets, liabilities and equity) at the end of the time period. The statement of cash flows and the statement of changes in equity provide detail of how the company's financial position changed during the time period. One implication of the time period assumption is that we have to make estimates and judgments at the end of the time period to correctly decide which events need to be reported in the current time period and which ones in the next. Revenue recognition and matching principles are relevant to time period assumption. Revenue recognition principle provides guidance on when to record revenue while matching concept tells us how to reach an accurate net income figure by creating 1-1 correspondence between revenues and expenses. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 14 Revenue Recognition Principle Revenue recognition principle tells that revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated reliability and when the amount is recoverable. Accrual basis of accounting is used in recognizing revenue which tells that revenue is to be recognized ignoring when the cash inflows occur. Examples 1. A telecommunication company sells talk time through scratch cards. No revenue is recognized when the scratch card is sold, but it is recognized when the subscriber makes a call and consumes the talk time. 2. A monthly magazine receives 1,000 subscriptions of $240 to be paid at the beginning of the year. Each month it recognizes revenue worth $20,000 [($240 ’ 12) × 1,000]. 3. A media company recognizes revenue when the ads are aired even if the payment is not received or where payment is received in advance. In case where payment is received before the event triggering recognition of revenue happens, the debit goes to cash and credit to unearned revenue. In case the event triggering revenue recognition occurs before payment is received, the debit goes to accounts receivable and credit to revenue. Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance is required in this area. IAS 18 Revenue deals with recognition of revenue. Full Disclosure Principle Full disclosure principle is relevant to materiality concept. It requires that all material information has to be disclosed in the financial statements either on the face of the financial statements or in the notes to the financial statements. Examples 1. Accounting policies need to be disclosed because they help understand the basis of accounting. 2. Details of contingent liabilities, contingent assets, legal proceedings, etc. are also relevant to the decision making of users and hence need to be disclosed. 3. Significant events occurring after the date of the financial statements but before the issue of financial statements (i.e. events after the balance sheet date) need to be disclosed. 4. Details of property, plant and equipment cannot be presented on the face of the balance sheet, but a detailed schedule outlining movement in cost and accumulated depreciation should be presented in the notes. 5. Tax rate is expected to change in near future. This information needs to be disclosed. 6. The draft for a new legislation is presented in the legislative of the country in which the company operates. If passed, the law would subject the company to significant cleanup costs. The company has to disclose the information in the notes. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 15 7. The company sold one of its subsidiaries to the spouse of one of its directors. The information is material and needs disclosure. Historical Cost Concept Accounting is concerned with past events and it requires consistency and comparability that is why it requires the accounting transactions to be recorded at their historical costs. This is called historical cost concept. Historical cost is the value of a resource given up or a liability incurred to acquire an asset/service at the time when the resource was given up or the liability incurred. In subsequent periods when there is appreciation is value, the value is not recognized as an increase in assets value except where allowed or required by accounting standards. Examples 1. 100 units of an item were purchased one month back for $10 per unit. The price today is $11 per unit. The inventory shall appear on balance sheet at $1,000 and not at $1,100. 2. The company built its ERP in 2008 at a cost of $40 million. In 2010 it is estimated that the present value of the future benefits attributable to the ERP is $1 billion. The ERP shall stand on balance sheet at its historical costs less accumulated depreciation. The concept of historical cost is important because market values change so often that allowing reporting of assets and liabilities at current values would distort the whole fabric of accounting, impair comparability and makes accounting information unreliable. Matching Principle In order to reach accurate net income figure, the expenses incurred to earn the revenues recognized during the accounting period should be recognized in that time period and not in the next or previous. This is called matching principle of accounting. Examples 1. $2,000,000 worth of sales is made in 2010. Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of earnings is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000. 2. A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated. Matching principle is relevant to the time period assumption, the revenue recognition principle and it is at the heart of accrual basis of accounting. Matching Vs Accruals Vs Cash Basis In the accounting community, the expressions 'matching principle' and 'accruals basis of accounting' are often used interchangeably. Accruals basis of accounting requires recognition of income and expenses in the accounting periods to which they relate rather than on cash basis. Accruals basis of BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 16 accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash basis of accounting. However, the matching principle is a further refinement of the accruals concept. For example, accruals basis of accounting requires the recognition of the estimated tax expense in the current accounting period even though the actual settlement of the provision may occur in the subsequent period. However, matching principle would also necessitate the recognition of deferred tax in the accounting periods in which the temporary differences arise so as to 'match' the accounting profits with the tax charge recognized in the accounting period to the extent of the temporary differences. Relevance and Reliability Relevance and reliability are two of the four key qualitative characteristics of financial accounting information. The others being understandability and comparability. Relevance requires that the financial accounting information should be such that the users need it and it is expected to affect their decisions. Reliability. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. Faithful representation: Information must represent faithfully the transactions it purports to represent in order to be reliable. There is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the transactions or finding an appropriate method of measurement or presentation. Where measurement of the financial effects of an item is so uncertain, enterprises should not recognise such an item. Neutrality: Information must be free from bias to be reliable. Neutrality is lost if the financial statements are prepared so as to influence the user to make a judgement or decision in order to achieve a predetermined outcome. Completeness: Financial information must be complete, within the restrictions of materiality and cost, to be reliable. Omission may cause information to be misleading. Verifiability: Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. It means that different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation. Timeliness: Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older information is the less useful it is. Relevance and reliability are both critical for the quality of the financial information, but both are related such that an emphasis on one will hurt the other and vice versa. Hence, we have to trade-off between them. Accounting information is relevant when it is provided in time, but at early stages information is uncertain and hence less reliable. But if we wait to gain while the information gains reliability, its relevance is lost. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 17 Examples 1. After the balance sheet date but before the date of issue a company wants to dispose of one of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company waits they are expected to find more reliable information but that would cost them relevance. The information would be outdated and no longer very relevant. 2. After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken. Timeliness is the key to relevance. Materiality Concept Financial statements are prepared to help the users with their decisions. Hence, all such information which has the ability to affect the decisions of the users of financial statements is material and this property of information is called materiality. Items are material if their omission or misstatement would influence the economic decisions of users based on the financial statements. Examples 1. The government of the country in which the company operates in working on a new legislation which would seriously impair the company's operations in future. Although there are no figures involved but the impact is so large that disclosure is imminent. 2. The remuneration paid to the executives and the directors is material. 3. The accounting policies are material because they help the users understand the figures. Materiality might be based on a percentage of sales such as 0.5% of sales or on total assets. Materiality is helpful in determining which figures are to be reported on income statement and balance sheet and which one in the notes. It is also helpful in helping decide which items should appear as line items and which ones are aggregated with others. Substance Over Form While accounting for business transactions and other events, we measure and report the economic impact of an event instead of its legal form. This is called substance over form principle. Substance over form is critical for reliable financial reporting. It is particularly relevant in case of revenue recognition, sale and purchase agreements, etc. Examples 1. A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset. 2. A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is called sale and leaseback. Although the legal ownership has transferred but the BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 18 underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction. 3. If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts. Prudence Concept Accounting transactions and other events are sometimes uncertain but in order to be relevant we have to report them in time. We have to make estimates requiring judgment to counter the uncertainty. While making judgment we need to be cautious and prudent. Prudence is a key accounting principle which makes sure that assets and income are not overstated and liabilities and expenses are not understated. Examples 1. Bad debts are probable in many businesses, so they create a special contra-account to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized and hence prevents overstatement of assets. An expense called bad debts expense is also booked to stop net income from being overstated. 2. Some liabilities are contingent upon future occurrence or non-occurrence of an event such a law suit, etc. We judge the probability of occurrence of that event and if it is more than 50% we record a liability and corresponding expense at the most likely amount. Hence, we stop liability and expense from being understated. 3. Periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it does exceed, the impairment of fixed asset is recorded by reducing its carrying amount. Understandability Understandability refers to the quality of financial information which makes it understandable by people with reasonable background knowledge of business and economic activities. Understandability requires the information presented in financial reports to be concise, complete and clear in presentation. The information should be presented so as to facilitate the user of the information. However, understandability never prescribes any complex information to be omitted altogether due to its underlying difficulty in understanding. It just requires us to disclose the information systematically instead of presenting it haphazardly. Examples 1. Understandability would require the financial statements to be identified by presenting the name of the financial statement, the name of the entity and the period covered by the statement. 2. Understandability also requires the notes to be properly numbered and cross-referred to the original balance sheet and income statement items. For example the note number of BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 19 disclosure on leases should be mentioned in front of the lease payable line item appearing on the face of a balance sheet. 3. Financial instruments and derivatives are specialized instruments which require rigorous understanding of finance to properly understand the underlying economics. In such complexity we cannot omit the disclosure because it is not easily understandable. Comparability Comparability is one of the key qualities which accounting information must possess. Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another. The characteristic of comparability of financial statements is important because it allows us to compare a set of financial statements with those of prior periods and those of other companies. Comparability can usually be achieved through a combination of consistency and disclosure. Examples 1. We can compare 20X2 financial statements of ExxonMobil with its 20X1 financial statements to know whether performance and position improved or deteriorated. 2. We can compare the ExxonMobil financial statements with that of BP if both are prepared in accordance with same set of accounting standards, such as IFRS or US GAAP, etc. 3. When preparing 20X3 financial statements we are required to present with each of the 20X3 figure the corresponding 20X2 figures. This is done to add the characteristic of comparability to the financial statements. Consistency Concept The concept of consistency means that accounting methods once adopted must be applied consistently in future. Also same methods and techniques must be used for similar situations. It implies that a business must refrain from changing its accounting policy unless on reasonable grounds: a) There is a significant change in the nature of the operations or a review of the financial statements indicates a more appropriate presentation. b) A change in presentation is required by an IFRS. If for any valid reasons the accounting policy is changed, a business must disclose the nature of change, the reasons for the change and its effects on the items of financial statements. Consistency concept is important because of the need for comparability, that is, it enables investors and other users of financial statements to easily and correctly compare the financial statements of a company. Examples 1. Company A has been using declining balance depreciation method for its IT equipment. According to consistency concept it should continue to use declining balance depreciation method in respect of its IT equipment in the following periods. If the company wants to BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 20 change it to another depreciation method, say for example the straight line method, it must provide in its financial report, the reason(s) for the change, the nature of the change and the effects of the change on items such as accumulated depreciation. 2. Company B is a retailer dealing in shoes. It used first-in-first-out method of inventory valuation in respect of shoes at Branch X and weighted average inventory valuation method in respect of similar shoes at Branch Y. Here, the auditors must investigate whether there are any valid reasons for the different treatment of similar inventory located at different locations. If not, they must direct the company to use any one of the valuation method uniformly for the whole class of inventory. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 21 LESSON 05: CASH AND CREDIT TRANSACTIONS Business transactions are the interactions between businesses and their customers, suppliers and others with whom they do business. Transactions can be very simple, like buying a newspaper, or extremely complex, taking a long time and involving many companies or agencies. New technologies and management approaches are developing around the management of business transactions. The main types of business transaction are sale and purchase. Sales and purchases occur in two different ways, by cash or on credit. Cash transaction is one where the buyer pays cash to the seller at the time the goods or services are transferred. Cash book is a book of prime entry which records the receipts and payments of cash. With the help of cash book and bank statement can be checked at a point of time. A simple cash book is prepared like any ordinary account. The receipts are recorded in the debit side and the payments are recorded in the credit side of the cash book. Simple Cash book Receipts Payments Date Narrative Amount $ Date Narrative Amount $ Example1: Enter the following transaction in a simple cash book 201X $ May-01 Cash in hand 10,000 May-05 Received from Ram 5,000 May-15 Cash sales 8,000 May-28 Paid Susan 2,000 Solution Simple Cash Book Receipts Payments Date Narrative Amount Date Narrative Amount 20X1 $ 201X $ May -01 May -05 May-15 Balance b/d Received from Ram Cash sales 10,000 5,000 8,000 May -28 Paid Susan Balance c/f 2,000 21,000 23,000 23,000 Petty cash In every business, there will be a number of small expenses that have to be paid for in notes and coins, instead of by cheque or by other methods of payment. To make these payments, a supply of cash has to be kept on the business premises. This cash is called petty cash. The petty cash book is the book of prime entry which keeps a cumulative record of the small amount of cash received into and paid out of the cash float. There is usually an imprest system for petty BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 22 cash, whereby a certain amount of cash is held in the box, say $200. At regular interval or when cash run low, vouchers are added up and recorded, and the total of the vouchers is used as the amount by which to top up the imprest to $200 again. $ Cash in box X Total of voucher = top-up X Imprest amount X Example 2: The imprest amount is $100, and at the end of March the petty cashier decides to top up the float in the petty cash box. 201X $ Mar-01 Balance $100 for petty cash Mar-04 Paid bus fare 10 Mar-10 Paid postage and telegram 25 Mar-15 Sale of postage stamps 30 Mar-25 Paid for sundry expenses 50 Solution: Bank reconciliation A bank reconciliation is a comparison of a bank statement with the bank account in the general ledger. Differences between the balance on the bank statement and the balance in the ledger account will be errors or timing differences, and they should be identified and satisfactorily explained. A bank reconciliation is needed to identify and account for the differences between the general ledger bank account and the bank statement. By reconciling the figures in the ledger account with those in the bank statement we can ensure that both the books and the ledger account are accurate. - Error - Bank charges or bank interest - Timing differences Credit transaction With credit transactions, the point in time when a sale or purchase is recognised in the accounts of the business is not the same as the point in time when cash is eventually received or paid for the sale or purchase. There is a gap in time between the sale or purchase and the eventual cash settlement. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 23 “A credit transaction is a sale or a purchase which occurs some time earlier than cash is received or paid.” When a company orders and receives goods (or services) in advance of paying for them, we say that the company is purchasing the goods on account or on credit. The supplier of the goods on credit is referred to as a creditor. There is a need for personal accounts, most commonly for customers and suppliers, and these are contained in the receivables ledger and payables ledger. Personal account include details of transactions which have already been summarised in ledger accounts (e.g. sales invoices are recorded in sales and total receivables, payments to suppliers in the cash and total payables accounts). The personal accounts do not therefore form part of the double entry system, as otherwise transactions would be recorded twice over (i.e. two debits and two credits for each transaction). They are memorandum accounts only. The receivables ledger consists of a number of personal receivables accounts. They are separate accounts for each individual customer, and they enable a business to keep a continuous record of how much a customer owes the business at any time. A control account is an account in the general ledger in which a record is kept of the total value of a number of similar but individual items. A receivables control account is an account in which records are kept of transactions involving all receivables in total. It should agree with the total of the individual balances and act as a check to ensure that all transactions have been recorded correctly in the individual ledger accounts. Example 1: On 15 May 201X Cosmo purchased paper, card and frames worth $2,000 from Honor Soper on credit: Debit When invoices are entered in the sales day book. Credit When entries are made in the cash book in respect of payments received from customer or in the sales returns day book for goods (or services) returned. Example 2: Pet makes a sale for $1,000 worth of goods to Janice on credit Dr Trade receivables $1,000 Cr Sales $1,000 Being sale of $1,000 to Janice Dr Purchases $2,000 Cr Trade payables $2,000 Being purchases from Honor Soper BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 24 Section summary Control accounts Posted from With Agrees with Part of general ledger double entry? Total receivables Sales day book Sales returns day book Cash receipts day book Totals Receivables ledger balances in total  Total payables Purchase day book Purchase returns day book Cheque payments day book Totals Payable ledger balances in total  Memorandum Accounts Posted from With Agrees with Part of general ledger double entry? Receivables ledger As for control a/c Individual transactions Total receivables a/c  Payables ledger As for control a/c Individual transactions Total payables a/c  Reconciling control accounts with receivables and payables ledgers The control accounts should be balanced regularly (at least monthly), and the balance on the control account agreed with the schedule of the individual receivables' or payables' balances extracted from the sales or bought ledgers respectively. It is one of the sad facts of an accountant's life that more often than not the balance on the control account does not agree with the schedule of balances extracted, for one or more of the following reasons. - An incorrect amount may be posted to the control account because of a miscast of the total in the book of original entry (ie adding up incorrectly the total value of invoices or payments). - A transposition error may occur in posting an individual's balance from the book of prime entry to the memorandum ledger, eg the sale to C Cloning of $250 might be posted to his account as $520. - The list of balances extracted from the memorandum ledger may be incorrectly extracted or miscast. - Credit notes entered as invoices or invoices entered as credit notes in the control account (but correctly entered in the personal accounts). - Credit note entered as an invoice or invoice entered as a credit note in the personal accounts (but correctly entered in the control account). - Invoices posted to the wrong side in the control account (only). - Credit balances treated as Debit balances in the list of balances (eg. personal account debit balance treated as a credit balance). - Contra entries made in the personal accounts, but not in the control accounts. - Discounts entered in the personal ledgers not recorded in the control account (or vice-versa). BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 25 Accruals and prepayments Accrued expenses are expenses which relate to (ie have been incurred during) an accounting period but have not yet been paid. They are a charge against the profit for the period and they are shown in the statement of financial position as at the end of the period as a current liability. Prepayments are expenses which have already been paid but relate to a future accounting period. They are not charged against the profit of the current period, and they are shown in the statement of financial position at the end of the period as a current asset. Irrecoverable debts Some trade receivables may need to be written off as irrecoverable debts. Additionally, an allowance for receivables may be created. Rather than affecting individual customer balances, an allowance for receivables recognises the fact that ordinarily a certain proportion of all debts may not be collected. For some debts on the ledger, there may be little or no prospect of the business being paid, usually for one of the following reasons. - The customer has gone bankrupt. - The customer is out of business. - Dishonesty may be involved. - Customers in another country might be prevented from paying by the unexpected introduction of foreign exchange control restrictions by their country's government during the credit period. For one reason or another, therefore, a business might decide to give up expecting payment and to write the debt off. An allowance for receivables is a general estimate of the percentage of debts which are not expected to be repaid. It is based on past experience. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 26 LESSON 06: TRIAL BALANCE We have already seen that, via the technique of double entry bookkeeping, the dual aspect of accounting transactions is reflected in the accounts using debits and credits. It follows that if each transaction involves equal debit and credit entries, the total of all debits will equal the total of all credits. Although there is no foolproof method for making sure that all entries have been posted to correct ledger account, a technique which shows up the more obvious mistakes is to prepare a trial balance. Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the preparation of financial statements. It is usually prepared at the end of an accounting period to assist in the drafting of financial statements. Ledger balances are segregated into debit balances and credit balances. Asset and expense accounts appear on the debit side of the trial balance whereas liabilities, capital and income accounts appear on the credit side. If all accounting entries are recorded correctly and all the ledger balances are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of all credit balances. Purpose of a Trial Balance The trial balance also serves other purposes as follows. a) To provide summary values for certain key information (eg the totals of trade receivables and payables) b) To speed up the process of preparing the final accounts (through the provision of summary values and confirmation that certain errors have not occurred) The trial balance can be viewed as the point at which recording transactions (bookkeeping) ends and preparing the final accounts (accounting) commences. Itis important to note that, although the trial balance is useful for discovering some errors, there are certain types of error that will not be detected when a trial balance is prepared. Example: Following is an example of what a simple Trial Balance looks like (please see the next page): 1. Title provided at the top shows the name of the entity and accounting period end for which the trial balance has been prepared. 2. Account Title shows the name of the accounting ledgers from which the balances have been extracted. 3. Balances relating to assets and expenses are presented in the left column (debit side) whereas those relating to liabilities, income and equity are shown on the right column (credit side). 4. The sum of all debit and credit balances is shown at the bottom of their respective columns. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 27 ABC LTD Trial Balance as at 31 December 2012 Account Title Debit Credit $ $ Share Capital 15,000 Furniture & Fixture 5,000 Building 10,000 Creditor 5,000 Debtors 3,000 Cash 2,000 Sales 10,000 Cost of sales 8,000 General and Administration Expense 2,000 Total 30,000 30,000 Limitations of a trial balance If the basic principle of double entry has been correctly applied throughout the period it will be found that the credit balances equal debit balances in total. It does not matter in what order the various accounts are listed in the trial balance, because it is not a document that a business has to prepare. It is just a method used to test the accuracy of the double entry bookkeeping methods. If the balances of the trial balance are not equal, there must be an error in recording of transactions in the accounts or an error in balancing the individual accounts. A trial balance, however, will not disclosure the following types of errors. - The complete omission of a transaction, however neither a debit nor a credit is made (an error of omission). For example, if an invoice for purchases worth $200 was mislaid before it was recorded, the books would still balance. Both purchases and creditors would be understated by $200. - The posting of a debit or credit to the correct side of the ledger, but to a wrong account (sometimes called errors of commission). For example, if the invoice referred to above was entered as a credit to the account of a different supplier and the debit either correctly to purchases or incorrectly to an expense account, the books would be incorrect, but they should still balance. - Compensating errors (e.g. debit error of $100 is exactly cancelled by credit $100 error elsewhere). These are uncorrected errors which by coincidence cancel out. - Error of principle (e.g. cash received from customers being debited to the receivables account and credited to bank instead of the other way round). Another example of an error of principle is where a purchase of, say, $200 has been credited to sales and debited to receivables instead of debited to purchases and credited to payables. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 28 - Posting incorrect amounts. An example of this type of error would be when an invoice is misread and instead of the correct amount of say $600, $800 is posted as both a debit and credit. The trial balance would still balance. - Error of original entry. This arises where the original entry has been wrongly recorded in the day book. - Error of reversal. In this case debit and credit entries have been reversed. Possible errors which will be revealed by the trial balance: those errors which will be revealed by the trial balance are: - Error of partial omission (error of single entry). In this case either the debit or the credit entry will be missing. - Error of transposition, e.g. $209 posted as $290. This will be detected where the error is made on one entry. If the transposition error is made in both debit and credit postings, this will not be picked up by the trial balance. - Both entries posted to either debit or credit. - The wrong amount on one entry. When an occurred error results in an imbalance between total debits and total credits in the ledger accounts, the first step is to open a suspense account. A suspense account is an account showing a balance equal to the difference in a trial balance. A suspense account is a temporary account which can be opened for a number of reasons. The most common reasons are as follows: - A trial balance is drawn up which does not balance - The bookkeeper of a business knows where to post the credit side of a transaction, but does not know where to post the debit (or vice versa). It must be stressed that a suspense account can only be temporary. Postings to a suspense account are only made when the bookkeeper doesn't know yet what to do, or when an error has occurred. Mysteries must be solved, and errors must be corrected. Under no circumstances should there still be a suspense account when it comes to preparing the statement of financial position of a business. The suspense account must be cleared and all the correcting entries made before the final accounts are drawn up. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 29 LESSON 07: FINANCIAL STATEMENTS A financial statement is a formal record of the financial activities of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form easy to understand. They typically include basic financial statements, accompanied by a management discussion and analysis. For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements. Purpose of financial statements Financial statements are a structured representation of the financial position and financial performance of an entity. The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management‘s stewardship of the resources entrusted to it. To meet this objective, financial statements provide information about an entity‘s: a) Assets; b) Liabilities; c) Equity; d) Income and expenses, including gains and losses; e) Contributions by and distributions to owners in their capacity as owners; and f) Cash flows. This information, along with other information in the notes, assists users of financial statements in predicting the entity‘s future cash flows and, in particular, their timing and certainty. A complete set of financial statements comprises: a) A statement of financial position as at the end of the period; b) A statement of comprehensive income for the period; c) A statement of changes in equity for the period; d) A statement of cash flows for the period; e) Notes, comprising a summary of significant accounting policies and other explanatory information; and f) A statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. A. INCOME STATEMENT The income statement is one of the major financial statements used by accountants and business owners. The income statement is sometimes referred to as the profit and loss statement (P&L), statement of operations, or statement of income. The income statement shows in detail how the profit or loss of a period has been made. The income statement matches the revenue earned in a period with the costs incurred in earning it. It is usual to BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 30 distinguish between a gross profit (sales revenue less the cost of goods sold) and a net profit (being the gross profit less the expenses of selling, distribution, administration etc). If costs exceed revenue the business made a loss. The income generated will be used to finance the activities of the business which incur costs: purchasing ready-made goods for onward sale, purchasing equipment, paying expenses such as staff salaries, stationery, lighting and heating, rent and so on. Periodically the organization will prepare an income statement. The period of time that the statement covers is chosen by the business and will vary. For example, the heading may state: "For the Three Months Ended December 31, 2012" "For the Four Weeks Ended December 27, 2012" "For the Fiscal Year Ended June 30, 2012" People pay attention to the profitability of a company for many reasons. For example, if a company was not able to operate profitably - the bottom line of the income statement indicates a net loss - a banker/lender/creditor may be hesitant to extend additional credit to the company. On the other hand, a company that has operated profitably - the bottom line of the income statement indicates a net income - demonstrated its ability to use borrowed and invested funds in a successful manner. A company's ability to operate profitably is important to current lenders and investors, potential lenders and investors, company management, competitors, government agencies, labour unions, and others. The format of the income statement or the profit and loss statement will vary according to the complexity of the business activities. An entity shall present an analysis of expenses recognised in profit or loss using a classification based on either their nature or their function within the entity, whichever provides information that is reliable and more relevant. Expenses are sub-classified to highlight components of financial performance that may differ in terms of frequency, potential for gain or loss and predictability. This analysis is provided in one of two forms: The first form of analysis is the „nature of expense‟ method. An entity aggregates expenses within profit or loss according to their nature (for example, depreciation, purchases of materials, transport costs, employee benefits and advertising costs), and does not reallocate them among functions within the entity. This method may be simple to apply because no allocations of expenses to functional classifications are necessary. An example of a classification using the nature of expense method is as follows: Revenue x Other income x Changes in inventories of finished goods and work in progress x Raw materials and consumables used x Employee benefits expense x Depreciation and amortisation expense x Other expenses x Total expenses (x) Profit before tax x BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 31 The second form of analysis is the „function of expense‟ or „cost of sales‟ method and classifies expenses according to their function as part of cost of sales or, for example, the costs of distribution or administrative activities. At a minimum, an entity discloses its cost of sales under this method separately from other expenses. This method can provide more relevant information to users than the classification of expenses by nature, but allocating costs to functions may require arbitrary allocations and involve considerable judgment. An example of a classification using the function of expense method is as follows: Revenue x Cost of sales (x) Gross profit x Other income x Distribution costs (x) Administrative expenses (x) Other expenses (x) Profit before tax x An entity classifying expenses by function shall disclose additional information on the nature of expenses, including depreciation and amortisation expense and employee benefits expense. If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the profit and loss statement is labelled as net income. If the net amount (or bottom line) is negative, there is a net loss. Revenues and gains Revenues from primary activities are often referred to as operating revenues. Revenues from secondary activities are often referred to as non-operating revenues. These are the amounts a business earns outside of purchasing and selling goods and services. As is true with operating revenues, non-operating revenues are reported on the profit and loss statement during the period when they are earned, not when the cash is collected. Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction that is outside of the primary activities of most businesses. A gain is reported on the income statement as the net of two amounts: the proceeds received from the sale of a long-term asset minus the amount listed for that item on the company's books (book value). A gain occurs when the proceeds are more than the book value. This gain should not be reported as sales revenues, nor should it be shown as part of the merchandiser's primary activities. Instead, the gain will appear in a section on the income statement labelled as "non-operating gains" or "other income". The gain is reported in the period when the disposal occurred. Expenses and Losses Expenses involved in primary activities are expenses that are incurred in order to earn normal operating revenues. Under the accrual basis of accounting, the cost of goods sold is matched with the related sales on the income statement, regardless of when the supplier of the merchandise is paid. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 32 The income statements or profit and loss statements of merchandisers and manufacturers will use a separate line for the cost of goods sold. The other expenses involved in their primary activities will either be grouped together as operating expenses or subdivided into the categories "selling" and "administrative." Expenses from secondary activities are referred to as non-operating expenses. For example, interest expense is a non-operating expense because it involves the finance function of the business, rather than the primary activities of buying/producing and selling. Losses such as the loss from the sale of long-term assets, or the loss on lawsuits result from a transaction that is outside of a business's primary activities. A loss is reported as the net of two amounts: the amount listed for the item on the company's books (book value) minus the proceeds received from the sale. A loss occurs when the proceeds are less than the book value. Using the above multiple-step income statement as an example, we see that there are three steps needed to arrive at the bottom line Net Income: Step 1. Cost of goods sold is subtracted from net sales to arrive at the gross profit. Gross profit = Net sales – Cost of goods sold Gross profit = $100,000 – $75,000 Gross profit = $25,000 Step 2. Operating expenses are subtracted from gross profit to arrive at operating income. Operating income = Gross profit – Operating expenses Operating income = $25,000 – $13,000 Operating income = $12,000 Step 3. The net amount of non-operating revenues, gains, non-operating expenses and losses is combined with the operating income to arrive at the net income or net loss Net income = Operating income + Non-operating items Net income = $12,000 + $6,000 Net income = $18,000 BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 33 B. STATEMENT OF FINANCIAL POSITION (Balance sheet) A statement of financial position shows the financial position of a business at a given moment in time. It is a statement of the assets, liabilities and owner‘s equity of a business at a given point in time. It is draw up ―as at‖ a particular date. Typically, the statement is prepared to show the assets, liabilities and owner‘s equity as at the end of the accounting period to which the financial statements relate. A statement of financial position is therefore very similar to the accounting equation. In fact, there are only two differences between a statement of financial position and the accounting equation, which are as follows: - The manner of format in which the assets and liabilities are presented. - The extra detail which is usually contained in a statement of financial position. For many businesses, the way in which assets and liabilities are categorised and presented is a matter of choice, and you may come across different formats. The format below should help you see how a typical statement of financial position is compiled. Sample: STATEMENT OF FINANCIAL POSITION AS AT 31 DEC 2012 ASSETS Non-current assets Property, plant and equipment x Intangible assets x x Current assets Inventory x Receivables x Cash at bank x Cash in hand x x x OWNER’S EQUITY Common stock x Retained earnings x x LIABILITIES Non-current liabilities Loan x Bonds payable x x Current liabilities Payables x Bank overdraft x x x BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 34 Assets Assets are things that the company owns or has the use of. Usually these asset accounts will have debit balances. Contra assets are asset accounts with credit balances. (A credit balance in an asset account is contrary - or contra - to an asset account's usual debit balance). Examples of contra asset accounts include: Allowance for Doubtful Accounts; Accumulated Depreciation... Non-current assets A non-current asset is an asset acquired for use within the business (rather than for selling to a customer), with a view to earning income or making profits from its use, either directly or indirectly, over more than one accounting period. An item must satisfy two further conditions: - It must be used by the business. - The asset must have a ―life‖ in use of more than one year. Non-current assets are for long-term use and include land, buildings, leasehold improvements, equipment, machinery and vehicles. Intangible assets: These are assets that you cannot touch or see but that have value. Intangible assets include franchise rights, goodwill, non-compete agreements, patents and many other items. Current assets Current assets are items owned by the business with the intention of turning them into cash within one year. Assets are ―current‖ in the sense that they are continually flowing through the business. They include cash, stocks and other liquid investments, accounts receivable, inventory and prepaid expenses... An entity shall classify an asset as current when: - It expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; - It holds the asset primarily for the purpose of trading; - It expects to realise the asset within twelve months after the reporting period; or - The asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. An entity shall classify all other assets as non-current. Liabilities An entity shall classify a liability as current when: - It expects to settle the liability in its normal operating cycle; - It holds the liability primarily for the purpose of trading; - The liability is due to be settled within twelve months after the reporting period; or - It does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. An entity shall classify all other liabilities as non-current. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 35 Current liabilities are accounts payable of the business that must be paid within a short period of time (by convention, within a year). Currents are debts which are payable within one year. Examples of current liabilities include loans repayable in one year, bank overdrafts, trade payables and income tax due. Non-current liabilities Non-current liabilities are debts which are not payable within the ―short-term‖ and so any liability which is not current must be non-current (more than one year). Examples of non-current liabilities are bank or venture capital fund loans repayable after more than one year. Where a loan is being repaid over a period longer than one year, the amount outstanding will be split. The amount due within one year will be shown under ―current liabilities‖ and the balance will be shown under ―non-current liabilities‖. Owner’s equity Owner‘s equity will include the amounts invested by the owner(s) in the business, plus profits earned and retained by the business. Components include common stock, paid-in-capital (amounts invested not involving a stock purchase) and retained earnings (cumulative earnings since inception of the business less dividends paid to stockholders), Treasury Stock, Share premium, etc. Owner's equity is sometimes referred to as the book value of the company, because owner's equity is equal to the reported asset amounts minus the reported liability amounts. "Owner's Equity" is the words used on the balance sheet when the company is a sole proprietorship. If the company is a corporation, the words Stockholders' Equity is used instead of Owner's Equity. Contra owner's equity accounts are a category of owner equity accounts with debit balances. (A debit balance in an owner's equity account is contrary - or contra - to an owner's equity account's usual credit balance). An example of a contra owner's equity account is a sole proprietorship‗s Drawing. An example of a contra stockholders' equity account is Treasury Stock. C. STATEMENT OF CASH FLOW The cash-flow statement is designed to convert the accrual basis of accounting used to prepare the income statement and balance sheet back to a cash basis. This may sound redundant, but it is necessary. The accrual basis of accounting generally is preferred for the income statement and balance sheet because it more accurately matches revenue sources to the expenses incurred generating those specific revenue sources. However, it also is important to analyze the actual level of cash flowing into and out of the business. The period of time that the statement covers is chosen by the company. For example, the heading may state "For the Three Months Ended December 31, 2012" or "The Fiscal Year Ended September 30, 2012". The cash-flow statement is one of the most useful financial management tools you will have to run your business. The cash flow statement organizes and reports the cash generated and used in the following categories: BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 36 1. Net cash flow from operating activities: Operating activities are the daily internal activities of a business that either require cash or generate it. They include cash collections from customers; cash paid to suppliers and employees; cash paid for operating expenses, interest and taxes; and cash revenue from interest dividends. 2. Net cash flow from investing activities: Investing activities are discretionary investments made by management. These primarily consist of the purchase (or sale) of equipment. 3. Net cash flow from financing activities: Financing activities are those external sources and uses of cash that affect cash flow. These include sales of common stock, changes in short- or long-term loans and dividends paid. 4. Net change in cash and marketable securities: The results of the first three calculations are used to determine the total change in cash and marketable securities caused by fluctuations in operating, investing and financing cash flow. This number is then checked against the change in cash reflected on the balance sheet from period to period to verify that the calculation has been done correctly. Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement. Here are a few ways the statement of cash flows is used. 1. The cash from operating activities is compared to the company's net income. If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality". If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash. 2. Some investors believe that "cash is king". The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value. 3. Some financial models are based upon cash flow. Reporting cash flows from operating activities The standard offers a choice of method for this part of the statement of cash flows. a) Direct method: disclose major classes of gross cash receipts and gross cash payments. $'000 $'000 Cash flows from operating activities Cash receipts from customers X Cash paid to suppliers and employees (X) Cash generated from operations X Interest paid (X) Income taxes paid (X) Net cash from operating activities X BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 37 b) Indirect method: net profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. Profit before interest and tax (income statement)* Add depreciation Loss (profit) on sale of non-current assets (Increase)/decrease in inventories (Increase)/decrease in receivables Increase/(decrease) in payables Cash generated from operations Interest (paid)/received Income taxes paid Net cash flows from operating activities $ X X X (X)/X (X)/X X/(X) X (X) (X) X * Take profit before tax and add back any interest expense The direct method discloses information, not available elsewhere in the financial statements, which could be of use in estimating future cash flows. However, the indirect method is simpler and more widely used. Interest and dividends Cash flows from interest and dividends received and paid should each be disclosed separately. Each should be classified in a consistent manner from period to period. a) Interest paid should be classified as an operating cash flow or a financing cash flow. b) Interest received and dividends received should be classified as operating cash flows or, more usually, as investing cash flows. c) Dividends paid by the enterprise should be classified as an operating cash flow, so that users can assess the enterprise's ability to pay dividends out of operating cash flows, or more usually, as a financing cash flow, showing the cost of obtaining financial resources. D. INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS The central company, called a parent, generally owns most or all of the shares in the other companies, which are called subsidiaries. The parent company usually controls the subsidiary by owning most of the shares in that company, but share ownership is not always the same as control, which can arise in other ways. Businesses may operate as a group for all sorts of practical reasons. If you were going out for a pizza, you might go to Pizza Hut; if you wanted some fried chicken you might go to KFC. Both sound more appetising than 'Yum! Brands Inc', the parent company of these subsidiaries. However, from the legal point of view, the results of a group must be presented as a whole. In other words, they need to be consolidated. Consolidation will be defined more formally later in the chapter. Basically, it means presenting the results of a group of companies as if they were a single company. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 38 Basic principles of consolidation There are two companies, BagiaCo and Lotte. BagiaCo owns 80% of the shares in Lotte. BagiaCo has a head office building worth $100,000. Lotte has a factory worth $80,000. Remember that consolidation means presenting the results of two or more companies as if they were one. Adding together You add together the values of the head office building and the factory to get an asset, land and buildings, in the group accounts of $100,000 + $80,000 = $180,000. So far so good; this is what you would expect consolidation to mean. Intra-group debts Suppose BagiaCo has receivables of $40,000 and Lotte has receivables of $30,000. Included in the receivables of BagiaCo is $5,000 owed by Lotte. Remember again that consolidation means presenting the results of the two companies as if they were one. Do we then simply add together $40,000 and $30,000 to arrive at the figure for consolidated receivables? We cannot simply do this, because $5,000 of the receivables is owed within the group. This amount is irrelevant when we consider what the group as a whole is owed. Suppose further that BagiaCo has payables of$50,000 and Lotte has payables of $45,000. We already know that $5,000 of Lotte's payables is a balance owed to BagiaCo. If we just added the figures together, we would not reflect fairly the amount the group owes to the outside world. The outside world does not care what these companies owe to each other - that is an internal matter for the group. Cancellation of like items To arrive at a fair picture we eliminate both the receivable of $5,000 in BagiaCo's books and the payable of $5,000 in Lotte's books. Only then do we consolidate by adding together. Consolidated receivables = $40,000 + $30,000 – $5,000 = $65,000 Consolidated payables = $50,000 + $45,000 – $5,000 = $90,000 So far we have established that consolidation means adding together any items that are not eliminated as internal to the group. Going back to the example, however, we see that BagiaCo only owns 80% of Lotte. Should we not then add BagiaCo's assets and liabilities to 80% of Lotte's? Consolidate as if you owned everything The answer is no. BagiaCo controls Lotte, its subsidiary. The directors of BagiaCo can visit all of Lotte's factory, if they wish, not just 80% of it. So the figure for consolidated land and buildings is $100,000 plus $80,000 as stated above. Show the extent to which you do not own everything However, if we just add the figures together, we are not telling the whole story. There may well be one or more shareholders who own the remaining 20% of the shares in Lotte Ltd. These shareholders cannot visit 20% of the factory or tell 20% of the workforce what to do, but they do have an interest in 20% of the net assets of Lotte. The answer is to show this non-controlling interest separately in the equity section of the consolidated statement of financial position. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 39 Summary  Consolidation means adding together (uncancelled items).  Consolidation means cancellation of like items internal to the group.  Consolidate as if you owned everything then show the extent to which you do not. Keep these basic principles in mind as you work through the detailed techniques of consolidated financial statements. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 40 LESSON 08: EXTERNAL AUDIT An external audit is a type of assurance engagement that is carried out by an auditor to give an independent opinion on a set of financial statements. The objective of an audit of financial statements is to enable the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria. The outcome of the evaluation or measurement of a subject matter is the information that results from applying the criteria. The need for certain companies‘ financial statements to be audited by an independent external auditor has been a cornerstone of confidence in the world‘s financial systems. The benefit of an audit is that it provides assurance that management has presented a ‗true and fair‘ view of a company‘s financial performance and position. An audit underpins the trust and obligation of stewardship between those who manage a company and those who own it or otherwise have a need for a ‗true and fair‘ view, the stakeholders. In general, an audit consists of evaluation of a subject matter with a view to express an opinion on whether the subject matter is fairly presented. There are different types of audits that can be performed depending on the subject matter under consideration, for example: 1. Audit of financial statements 2. Audit of internal control over financial reporting 3. Compliance audit Companies prepare their financial statements in accordance with a framework of generally accepted accounting principles (GAAP) relevant to their country, also referred to broadly as accounting standards or financial reporting standards. The fair presentation of those financial statements is evaluated by independent auditors using a framework of generally accepted auditing standards (GAAS) which set out requirements and guidance on how to conduct an audit, also referred to simply as auditing standards. How is the audit conducted? - The organisation's management prepares the financial statements. They must be prepared in accordance with legal requirements and financial reporting standards. - The organisation's directors approve the financial statements. - Auditors start their examination by gaining an understanding of the organisation's activities, and considering the economic and industry issues that might have affected the business during the reporting period. - For each major activity listed in the financial statements, auditors identify and assess any risks which could have a significant impact on the financial position or financial performance, and also some of the measures (called internal controls) that the organisation has put in place to mitigate those risks. BIG STEP TRAINING English for Accounting and Auditing We ADD VALUE to your packaging process! 41 - Based on the risks and controls identified, auditors consider what management has done to ensure the financial report is accurate, and examine supporting evidence. - Auditors then make a judgement as to whether the financial statement taken as a whole presents a true and fair view of the financial results and position of the organisation and its cash flows, and is in compliance with financial reporting standards and, if applicable, t